Wednesday, March 23, 2011

I have been sitting on this post for while pending the publication of an article by Mellisa Davis (of The Street Sweeper). She has now gone public quoting me - so here is something I have been working on.

High growth subprime companies - a brief stylized history

Until the crisis one of the staples of my life was financial institutions which under provided for inevitable losses and grew really fast. Examples include Metris and Americredit - both of which collapsed, partially recovered and were eventually taken over.

Before the collapse they had less-than-prime lending businesses in credit cards and auto loans respectively. Metris was the more pure example. Another example was the credit card business of Circuit City.

These companies understated losses. That made them seem profitable. That profitability is only temporary because eventually it becomes obvious to even the most stubborn and blinkered management that the loans are not going to pay. When that happens a charge is inevitable - and future profitability winds up at a lower level (more akin to economic reality).

However the companies in question deferred the day of reckoning. They did this a couple of ways. First when someone could not pay their loan they tended to extend them more credit. Metris’s average balance outstanding went above $4000 (or more than double average balances at similar companies). That meant that when the losses (inevitably) came they were bigger.

The second way that they deferred the day of reckoning was just to grow really really fast. After all, if you don’t recognize any losses on new loans, then filling your portfolio with new loans meant your aggregate credit looked OK, even if the old loans were toxic. The denial solution de jour was hypergrowth. The hypergrowth hid problems and also (incidentally) drove stocks to the moon giving management ample opportunity to cash out. In other words the path that made management rich was to make the problem bigger and bigger.

Sometimes before they blew up (and they inevitably blew up) you would get a signal: a quarter with an unexpected “reserve adjustment”. Reserve adjustment being a (belated) admission that the reserves were not adequate. Sometimes there was no signal except insider selling. Mostly even the insider selling was not a good signal because the insiders were always selling.

Lesson from this

There is a lesson I drew from this. Be very wary of fast-growing hyper profitable companies (especially companies in competitive industries) where the earnings are critically dependent on a reserve or variable that has to be estimated and on which the estimate is really a guess. This could be lending or insurance or large contract construction with contract warranties or in this case an oil company. The company in question is Northern Oil and Gas (Northern): a member of the S&P mid-cap index.

The Bakken shale oil plays

Northern Oil and Gas (and its little sister company Voyager Oil) own acreage and part shares in oil wells in the Bakken Shale. The Bakken Shale is one of the hotter properties in North America and is the subject of much promotion including several (sometimes anonymous) stock promotion blogs dedicated entirely to investing in the Bakken (see here, and here). Some have go-go names like “Million Dollar Way” appealing to relatively unsophisticated investors.

That said - the Bakken is a real oil field and it has real players and is producing a lot of oil.

The Bakken is a large (200 thousand square miles) mid depth (typically about 10 thousand feet) and not very wide (typically about 40 feet wide) oil bearing shale deposit. The area overlaps two American States (North Dakota and Montana) and one Canadian Province (Saskatchewan).

The field has been known about for many years because traditional oil fields underlie the Bakken and as the wells have been drilled, small quantities of light sweet crude have been logged. However the technology to extract oil in quantity from the Bakken is relatively recent and involves drilling down 10 thousand feet, kicking a horizontal well down 5-8 thousand feet, putting explosives down the well to crack the rock and then chemicals and water at very high pressure to extensively fracture the rock. And then the oil flows.

This has driven North Dakota oil production extremely well:

If you extrapolate graphs of production (something I don’t think you should do) then North Dakota overtakes Alaska in 2017 to be the major US oil producing state.

The problem with Bakken shale oil

The problem with Bakken shale oil is that the pores in the rock are tight and the rock needs to be fractured to extract it. It is a stylized fact of oil production that the tighter the rock the faster the oil well declines to a trickle - especially after the reservoir has been forcedly fractured.

This makes sense. If the rock is homogenous, quite porous and extends over a large area you would expect an oil well to flow for a very long time (multiple decades). However if the rock flows only a small amount of oil without fracturing (the small amount being the amount near the well bore) then when you fracture it it will flow many small amounts (the small amounts being amounts near the fracture system). And when you have exhausted the oil that happens to be near the fracture system then the flow should flow to a trickle as the rock is not very conducive to flow.

The risk with the Bakken is that the wells decline much faster than anticipated when the well is drilled and faster than anticipated in the accounts.

If this happens the company will have to take a “depletion adjustment” - the analog of my subprime company taking a “reserve adjustment”.

Now, also as an analog of the subprime company if the company, is drilling a whole lot of wells that are declining faster than anticipated, it can hide this through growth. After all, new wells don’t just stop flowing: they need to be old wells before that happens. And you can hide an aggregate decline problem by drilling like crazy. It just winds up being a bigger decline problem when you stop drilling.

And now you see my subprime oil company: it is Northern Oil and Gas and it is a doozy. Market cap is over $1.7 billion and the stock is up from 3 and a bit dollars to almost $30 since the beginning of 2009. It is - through partners - drilling like crazy.

It is a strange company, despite the large market cap it only has 11 staff. It takes minority shares in other companies oil wells. It does not drill anything itself. Every well seems to strike oil (that is what it is like in the Bakken) but because they do not operate the wells they only have limited insight into the decline rates. Shareholders have even less insight into the decline rates.

Searching for a benchmark for Bakken decline rates

I spent a lot of time trying to find a benchmark for oil-well decline rates in the Bakken. It's hard because people tend to keep this information confidential especially if they are bidding for local acreage. Also the technology to fracture Bakken wells is relatively new and so to some extent decline rates (especially over the out years) are just unknown. Still, I have heard good stories about individual wells that are flowing well after three years. I have heard horror stories about wells that are flowing at less than a barrel per day after one year. The average almost certainly lies in this range.

I was getting hung up on a benchmark when one of my favorite bloggers Peter Sacha stepped in with a really useful post. In it he picked apart the accounts of Petrobakken. Petrobakken is the major player in the Saskatchewan Bakken. What is more he had a decline curve.

Its only a decline curve for the first year - of production - and it is for a particularly big well (a seven stage frac). However, the initial flow rate was almost 250 barrels of oil per day and after 12 months this had declined to 75 barrels per day. It is a steep decline.

And it shows in Petrobakken’s accounts. Peter Sacha deadpans that the company likes to report “cash flow” which does not include the depletion allowance for wells. He then notes the company spent $812 million in capex most of which was to replace depleting wells. The cash flows are enormous - but the capital expenditure needed to maintain those cash flows are enormous - and that is because the depletion is rapid.

The key analytical assumption of this blog post is that we can compare decline rates for Petrobakken and Northern Oil. Both Petrobakken and Northern Oil are Bakken shale producers. Petrobakken is just much bigger and a little older and a little more experienced with decline rates. But both companies have a large spread of wells in similar areas so the average decline rate (relative to current production) should be similar.

Here are the accounts for the first nine months. (I don’t give the annual accounts because Northern Oil had an irregular depletion charge in the last quarter.)

For Petrobakken (and sorry you will need to click)

Note that over 9 months Petrobakken had 750 million in oil and gas sales before royalties and 654 million in net revenue. The depletion charge was 391 million. Depletion is 52 percent of gross revenue and almost 60 percent of net revenue. These wells deplete badly and the depletion charges are large.

Here is Northern Oil for the first nine months (and sorry again you will need to click).

Note that for Northern the gross revenue for the first nine months is 35.6 million (a very small fraction of Petrobakken). The depletion charge plus amortisation is 8.36 million.

Depletion and depreciation is only 23.5 percent of gross revenue.

Same field. Same geology. Less than half the depletion rate.

Same geology, same field suggests that the right approach to compare these companies is to assume the same depletion rate for both companies. Of course which depletion rate - Northern or Petrobakken?

We could assume that Northern is right and these fields could actually last a lot longer than Petrobakken thinks. In which case however you should buy Petrobakken as it will generate cash flow for years and will have already expensed the associated costs. If Northern is right don’t buy Northern - buy the company which is really earning far more than it says.

Altenatively Petrobakken is right and the right depletion rate is 52 percent of gross revenue. In that case for nine months the depletion plus depreciation at Northern should not equal 8.36 million it should equal that times 52/23.5 or 18.5 million. Instead of having income from operations of 14.4 million for the nine months as per stated you have income from operations of only 4.3 million. Income after tax is just over 3 million. That is for nine months - but hey - annualize it!

Oh, the market cap is over $1.7 billion.

If I do the depreciation as per Petrobakken (and I see no reason why I should not) then this stock is around 400 times earnings.

Obviously enough we are short.

It all swings on accounting for depletion - so who certifies the accounts?

All of this swings on accounting for depletion. If you use Northern’s accounting then this is a high growth high PE stock.

If you use Petrobakken’s accounting this is a lower growth stock with much higher PE and less prospects.

At that point I ask who is certifying the accounts?

Well the auditor is Mantyla McReynolds. Have you never heard of them? Nor had I and I am a connoisseur of obscure audit firms.

First I checked whether they were a local firm. No such luck. They are based in Salt Lake City and Northern Oil is based in Wayzata Minnesota. That is 1254 miles away according to Google maps. They went out of their way to find this auditor.

So who does Mantyla McReynolds audit? I went through the SEC database to see who else is audited by them and this is what I found:

Northern Oil and its sister company Voyager Oil. (Voyager is run by family members of the executive of Northern and there are some related party transactions.)

You get the idea. We are critically dependent on an estimated accounting expense (depletion) that is low compared to the competition (the far more established Petrobakken) . Further, these estimates are certified by an auditor most associated with penny stocks. Moreover, that auditor was chosen despite being over a thousand miles away and having no obvious expertise in oil and gas.

And despite all this advantage the company took a small reserve adjustment in the fourth quarter. (Isn't a depletion charge the first warning? My guess - some well actually ran dry!)

You can imagine that all this made me uncomfortable with the stock.

Alas Melissa Davis (at the Street Sweeper) has found far more about the stock than me. And none of it raises my comfort level.

What the Street Sweeper found

Remember my issue here is the accounting for depletion. The whole valuation, indeed the whole story swings on the depletion numbers, and Petrobakken gives you a good reason to doubt the depletion numbers.

I recommend you read the Street Sweeper piece. However, given that I am obsessed by the accounting, I thought you should focus on the CFO. Here is what the Street Sweeper says:

Very informative post, as always. I have two points of contention that if you can answer, would cause me to join you on the short side:

1) Do you have any reasonable rationale for using gross sales as the basis against which to index depletion expense? Why not gross property? I can think of many innocuous reasons why gross sales might diverge from depletion expense levels in any one year.

2) Although the auditors sign the opinion, it is my understanding that they more or less 'rely' on the 3rd party reserve engineer's report for technical data regarding reserves, which would include or at least greatly influence determined depletion rates. Therefore, if one were to question the validity of the depletion expense levels, would it not be more appropriate to investigate the competence of the reserve engineering firm, rather than the auditors?

first, you have made me a bunch of money on CAGC, so i'm grateful. i dont know anything about the company that you are reporting on. i am in oil and gas private euity and we are doing a deal in ND right now. the only thing i wanted to point out is that the only way to get to ND from anywhere it seems in the us is minneapolis (via airplane). it makes sense that the company would turn to a minneapolis accting firm (from a geographical perspective), and thus the 1200 miles away part isnt the reason i would be suspicious. im not saying the accounting firm isnt crap, or the stock is a buy or anything like that, but i thought you'd benefit from the above knowledge--minor detail i know, but just wanted to pitch in.

However, on this post, you are looking in the wrong direction. If you're investing in junior oil E&P's, earnings and financial depletion rates are largely irrelevant. I've analyzed hundreds of juniors throughout my career and have never considered earnings (because they are meaningless). In fact, I can't think of any juniors with any "earnings". They don't operate for earnings and no management team would ever operate with earnings in mind. They operate to grow reserves and production to then sell themselves to an intermediate.

What you have to look at is a sum-of-the-parts analysis based on acreage, reserves and production. A good place to start would be to look at comparable transactions. The best comp you could look at for NOG would be NuLoch Resources, which recently was acquired by Magnum Hunter. This deal marked non-operated ND Bakken / Three Forks acreage at ~$2,500 - $3,500 per acre. All-in, the company sold for $140,000 / boe/d and $35.50 / P+P boe.

I have never analyzed NOG before, but if we apply these metrics ($140,000 / boe/d), we get an intrinsic value for NOG of $14.00 per share, 50% less than the current stock price. I agree NOG's valuation looks stretched.

Also, your use of PBN's SE Saskatchewan wells as an analog for NOG's wells was way off. The Bakken at Taylorton is substantially thinner and produces at much lower rates than the formation at Williams or Mountrail. Just look at the wells - you see quite a few in ND producing >1,000 boe/d, but a Sask well at ~250 / boe/d would be rare. The type curve on Sask Bakken is more like IP30 of ~200 / boe/d. Wells in ND are much more productive, however they cost significantly more to drill and complete, so generally the economics are similar.

Just some thoughts. Thanks for the short idea, it seems like a good one. Cheers!

I suggest you talk to NOG before assuming that the decline rates for their wells are similar to those of the large base of Petrobakken, who is in an entirely different part of the region, which is less prospective in reserve/well by the history, and not even in the formal Williston Basin to my understanding. Even within the Williston, there are regions w/ very different EUR's, decline curves and net effective depletion rates. I just think it is likely a leap to make the direct comparison. Further depletion rates are based on reserve and declined curves evaluated by reserve engineers, who are generally very conservative, and who know a lot more about reserve, decline curves, etc then we do. And as the last several years show in the Wiliston, the EUR's have been rising not falling short of the reserve enegineer estimates. Look at the well curves on the BEXP presentations, where the latest well have consitently performed better then the earlier wells, and better then the assume EUR for the reserve reprots. The instance in the industry of reserves being reduced outside of a large commodity price decline are rare in my experience. You can deny this about reserve engineers, but that suggest you have an agenda, and have not worked in the oil area very much. Finally, the whole premise that the decline rates are steep and not well understood or accounted for in the eocomics is a reach. We all know that the unconventional resource plays have steep decline curves, but despite this the paybacks remain very short and the IRR's very high (>100% in the Williston Bakken).

Going to add to some of the comments left earlier:1) Contrary to the assertion in your article, depletion is a normal part of the E&P process and decline curves of 30% are relatively common in more mature regions such as the US. What matters more than depletion is the ultimate recovery of resource (UER) from the well. The rates of recovery do affect the IRR of the project, but numerous other factors come into play here.2) Depletion curves are not linear, but asymptotic and wells may continue to produce for very long periods, albeit at fairly low rates.3) The Bakken field is not homegenous, and the results from PBR wells which lie in a much thinner part of the play are in no way comparable to NOG or other players in the 'fairway' of the play.

Your points are totally without merit as are street sweepers! Although I hope you are investigated by the SEC, I hope your BS is bought by all of your cronies that are leaches for a few more days so that I can continue buying stock.

You don't appear to know much about decline rates given the fact that you are comparing PetroBakken to NOG. Try looking at companies in the same state. Then dig a little deeper and educate yourself on decline curves in various counties in North Dakota.I will help you out...the state of North Dakota has a website where you can buy a subscription for about $100 to see every companies wells that have been drilled. You will be able to get monthly production by BOE/d for all of NOG's partners wells!

Effectively you are saying companies like WLL, BEXP, EOG, CLR KOG, HE'S, XOM, WMB, QEP and Slawson are all frauds! Because that is who drills NOG's wells. Maybe once you have spent a little time doing some due diligence you will find yourself in short squeeze. I love making you guys sweat when everyone catches onto your antics.

Your analogy to subprime is laughable! Feel free to keep it up, cause I love lighting you leaches up.

Not sure how many shares you are short, but street sweeper short 50k is hysterical...small investors think this sounds like a lot to them when some only have the ability to buy/short a few hundred shares, but you are going to get lit up next week!

Herb Greenberg used to talk about the "hostile reactometer" when he published something negative on a stock. When reaction was really hostile he usually turned out to be right.

The above post meets the really hostile test - but in fairness several comments I got via email argued in a gentle - and reasoned - way that I was wrong about some element or other of my analysis. I respectfully disagree with the basic tenet - which was that the decline rate does not matter.

For these fields which are deep and tight it will wind up being the main thing that matters.

I wish the more moderate comments were put on the blog. This stock is so expensive I have considerable margin of safety around the short.

You might want to take a look at the following assesment of decline curves: http://www.oilandgasevaluationreport.com/2010/03/articles/oil-patch-economics/shale-economics-watch-the-curve/ While not specifically focused on the Bakken, it shows decline curves of other plays in the US.Steep decline curves are just a way of life for the E&P industry, which is why these stocks typically only work in a rising price environment.

Interesting story. A simple (but possibly not conclusive) check might be to contrast the declines (or write-downs) of the operators of the NOG wells. NOG has no technical team, and must somewhat rely on the reserve reporting of the operators, so if they didn't match that may point to something. NOG is only booking a portion of each wells production, so one should in, in theory, be able to find the company booking the rest of the production and compare their write downs. After all, NOG is in no technical place to contradict the reservoir/exploitation team of the operator, right?

I have no dog in this fight and have moderate oil/gas knowledge on the buy side.

My understanding of DD&A is that it is calculated as follows:DD&A of oil and gas properties is calculated by multiplying the percentage of total proved reserve volumes produced during the year, by the “depletable base.” The depletable base represents our capitalized investment, net of accumulated DD&A and reductions of carrying value, plus future development costs related to proved undeveloped reserves.

Ryder Scott does the reserve work for NOG and they are, I think, respectable. So any shenanigans on DD&A would have to come from the non-reserve side of the equation, no? (Or are you implicating Ryder Scott too?)

Also, capitalized investment should be roughly a given. So is your argument that the game playing is on the "future development costs assumption?"

Is it possible that NOG's different model(don't they let others do most of the drilling) leads to the lower DD&A?

Love to hear your responses as it seems there could be a great trade here.

well based on the comparisons they give in today's press release of Oasis petrol and Brigham Exploration both use "successful efforts" method while NOG uses full cost. I really don't know what the effect would be if any but seems like it would be something to look into. maybe not.

The primary difference between these two methods is the treatment of exploratory dry hole costs. These costs are generally expensed under the successful efforts method when it is determined that measurable reserves do not exist. Geological and geophysical costs are also expensed under the successful efforts method. Under the full cost method, both dry hole costs and geological and geophysical costs are initially capitalized and classified as unevaluated properties pending determination of proved reserves. If no proved reserves are discovered, these costs are then amortized with all the costs in the full cost pool.

Someone needs to seriously learn about how depletion rates work in the industry.

Reserves writedowns, which is disclosed annually by a company in their AIF, would be where one would look to see how original reserves bookings may be rerated due to higher than anticipated depletion of wells.

Additionally, it is well known by investors that decline rates in tight oil plays are very large in the first years - it is the actual part of the decline where hyperbolic production moves to exponential that is important.

This blog post was completely and utterly inaccurate in the analysis (irrespective of the outcome recommendation), and the writer's understanding of oil and gas geology, engineering, and general industry knowledge is egregiously misleading.

Some observations - note, I work in the industry for a large company with substantial Bakken acreage, so this is not crackpot analysis.

1) Ryder Scott is a reliable reserve engineering firm - along with Netherland Sewell and DeGolyer & McNaughton - sort of the "Big Three" of reserve engineering. There are other dodgy firms out there that would raise more of a red flag in my opinion.

2) The economics in the Bakken are difficult, even with high oil prices, and especially if you are small and can't get the service crews you need to complete wells. The larger operators (XOM, Hess, Continental) can bully the service providers and slow smaller operators from completing their wells due to the intense competition.

3) Bakken oil receives a substantial discount to WTI (~$10 a barrel) because the expensive logistics

4) Weather issues hampered every operator in the region this winter and spring - imagine that, it snows heavily in North Dakota in the winter

5) As a "non-operator", NOG has no control over its capital budget

6) The decline rates are more harsh than any other field in the USA and the wells are more expensive than any other field in the USA

7) As a % of sales, the depletion costs are comparable to Oasis Petroleum and other pure play Bakken companies

8) The tax code and ability to expense intangible drilling costs make the analysis of E&Ps challenging - it could be possible that Petrobakken is aggressively expensing its IDCs while NOG's partners are more conservative with their costs. Remember, in E&P land, they actively manage the businesses to reduce their tax bills, increase cash flow and grow production. Most E&P companies are terrible long-term investments for these reasons, because they rarely return any capital to their shareholders.

9) I also just noticed after reviewing their 10-Q is that NOG has hedged much of their production at rates well below the current market prices.

So putting aside the fraud argument, there are 8 economical reasons to sell the stock.

However, I would argue that having low depletion costs as a % of sales is actually a more conservative approach to oil and gas accounting.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.